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We All Need A Little Diversity

We All Need A Little Diversity

Written by Tina Winter

A fund manager needs to know how to reduce the overall risk of their portfolio, even though they are purchasing risky assets. There are two main ways to do this – hedging and diversification.

Hedging means protecting an existing position by taking another position which will increase in value if the existing position decreases in value – effectively hedging your bet. We’ll look at this again but this article concentrates on diversification.

Putting all your eggs in one basketIf you were to ask your grandmother, she would no doubt advise you not to put all of your eggs in one basket. It’s obvious that it’s going to be less risky holding a number of shareholdings rather than just one. Diversification reduces risk because combining different asset classes or securities reduces the overall risk to less than the average risk of the individual securities – the downside risk of one investment could be offset by the upside risk of another. However, if all the investments held were to move in the same direction at the same time this would not work – for diversification to be effective you need investments that move in opposite directions to each other.

The degree of diversification depends on a statistical concept called correlation:

Positive correlation – two shares are positively correlated when they broadly move up and down together – they will be affected by similar factors, such as interest rates or consumer demand, and may well be in the same sector,

Negative correlation – two shares are negatively correlated when they tend to move in opposite directions from each other – an umbrella retailer and a sun tan lotion manufacturer perhaps?

No correlation – the returns of some companies or asset classes are not connected in any way to each other.

Correlation is measured by the correlation co-efficient – perfect positive correlation has a value of + 1, perfect negative correlation has a value of – 1 and no correlation has a value of zero.

Theoretically, the most effective diversification of risk comes from combining investments that are negatively correlated – one goes up when the other goes down – but this is not always easy to find in practice. Choosing companies in different sectors can help to achieve diversification. Adding companies from overseas markets can also add diversification – however global equity markets tend to have a moderate to strong positive correlation with each other. Investing in different asset classes, including alternative investments such as property, commodities and hedge funds can also assist in overall diversification of a portfolio and hence overall risk reduction.